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Daily Analysis 11 February 2022 (10-Minute Read)

Hello there,

A fantastic Friday to you as markets flail into the weekend.

In brief (TL:DR)

  • U.S. stocks plunged on Friday with the Dow Jones Industrial Average (-1.43%), S&P 500 (-1.90%) and the Nasdaq Composite (-2.78%) all caving on a potential Russian invasion of Ukraine.

  • Asian equities closed mostly lower on Friday amidst mounting geopolitical tension in Eastern Europe.

  • Benchmark U.S. 10-year Treasury yields inched lower to 1.943% (yields fall when bond prices rise) on demand for haven assets as tension simmer in Ukraine.

  • The dollar strengthened amidst growing geopolitical uncertainty.

  • Oil's soared, with March 2022 contracts for WTI Crude Oil (Nymex) (+3.58%) at US$93.10 as the U.S. warns of an imminent Russian invasion of Ukraine.

  • Gold strengthened with April 2022 contracts for Gold (Comex) (+3.58%) at US$1,842.10.

  • Bitcoin (-1.87%) pushed lower into the weekend at US$42,330 as traders contended with diminished risk appetite against a backdrop of growing geopolitical tension and monetary policy tightening.

In today's issue...

  1. U.S. Inflation Soars to Highest Level in Four Decades

  2. The Hunt for Havens

  3. Cryptocurrency Miners Cheer Reporting Rule Clarity

Market Overview

Investors are walking on eggshells as the U.S. warns that a Russian invasion of Ukraine is "imminent" and countries are advising their citizens to evacuate from Ukraine.

But will Moscow really launch a full scale invasion of Ukraine?

Probably not. Yet markets are responding as if it's an almost foregone conclusion that an invasion is inevitable.

A quick examination of Russia's history of past aggressions from its limited military action in Georgia and the propping up of the regime of Syrian President Bashar al-Assad all seem to suggest that if nothing else, Moscow is extremely calculated in its moves, extracting maximum gain at minimal cost.

Which is why a full-blown invasion of Ukraine would likely be beyond that calculus - the costs would be astronomical, for very little gain.

If nothing else, Russia is already getting what it wants - engagement from the West to sit at the table to discuss European security.

The siege mentality has left Russia feeling cornered as NATO tries to expand its influence, boxing in Moscow.

So despite all the saber rattling, the odds of a World War 3 type scenario are slim.

Asian markets finished most lower on Friday with Tokyo's Nikkei 225 (+0.42%) up, while Sydney’s ASX 200 (-0.98%), Seoul's Kospi Index (-0.87%) and Hong Kong's Hang Seng Index (-0.07%) all lower on concerns over the risk of a Russian invasion of Ukraine.

1. U.S. Inflation Soars to Highest Level in Four Decades

  • U.S. Consumer Price Index data soars to 7.5% last month, the highest in four decades

  • Pace of price increases is escalating, putting additional pressure on the U.S. Federal Reserve to act to reign in prices

Your move, U.S. Federal Reserve.

A higher-than-expected jump in Consumer Price Index data in January is putting increasing pressure on the U.S. Federal Reserve to get far more aggressive on interest rate hikes.

According to the U.S. Bureau of Labor Statistics, CPI surpassed economist expectations, rising 7.5% last month, or a whopping 0.6% from a month earlier and surging past its previous 40-year high of 7.0% on an annual basis recorded in December.

Traders dumped U.S. Treasuries, sending yields soaring (bond prices fall when yields rise) on bets of higher interest rates.

With the first Fed rate hikes just over a month away, pressure is mounting on the Fed to do more to reign in inflation.

But high inflation isn’t just a problem for central bank policymakers, it could also cause the Democratic Party which holds both the House of Representatives and the Senate (albeit by a sliver thin majority), to lose the legislature in the upcoming midterm elections.

And while bets are increasing that the Fed could roll out six 0.25% rate hikes by December, as well as a 0.5% hike by next month, policymakers have not committed to any specific pace for its tightening cycle, saying that the tempo and scale of rate increases would be data dependent.

But that presents a different set of problems for investors.

Historically, it has been near on impossible to aggressively tighten monetary policy without causing a ruinous recession.

And estimates by both the Biden administration and Fed policymakers suggest that price pressures will ebb by the end of this year, which could be wishful thinking or prescience.

It’s highly doubtful that the Fed has the appetite for a sharp rate hike akin to that of the Volcker era.

In the 1970’s, the rising cost of oil contributed to soaring inflation and saw then-U.S. Federal Reserve Chairman Paul Volcker picking up the gauntlet and ratcheting rates up by double-digits.

But the macroeconomic situation is far less obvious today – supply chain disruptions are contributing to price pressures in ways that are difficult to directly translate to their effect on inflation.

Which explains why the Fed is keeping its cards close to its chest.

European Central Bank President Christine Lagarde who recently opened the possibility for a hawkish pivot is now taking to warning that acting too fast on policy could choke the economy’s recovery.

And the Reserve Bank of Australia, has said that it will remain patient on policy, with Governor Philip Lowe reinforcing his lower-for-longer interest rate stance.

Traders may respond to data on a month-to-month basis, but the Fed, which needs to plan in years, may have a different set of considerations.

2. The Hunt for Havens

  • Soaring U.S. inflation has investors pouring into gold and other inflation-hedging solutions

  • Over the long run, equities have been the most reliable hedge against inflation

With the fastest pace of U.S. price increases in four decades, investors are actively searching for assets to weather the market storm, including in assets such as European equities, gold and even Asian resource companies.

Given how the central banks of the U.S. and Europe have embarked on relentless money-printing exercises in the over a decade since the 2008 Financial Crisis, prolonged underdevelopment of commodity extraction could set the existing players up for a massive windfall.

Inflation adjusted U.S. 10-year Treasury real yields have already jumped to -0.421% last Friday, the highest since last June.

But while investors are looking for cover for inflation, and the February print is likely to reinforce expectations of stubbornly higher prices, where they go from here on out is probably more relevant because the risk of policy mistakes is substantially higher.

Either the Fed will tighten too much and growth slows, which will require policymakers to backtrack, or it’ll be too slow, and real rates will remain firmly negative – both outcomes which will be positive for real assets, including gold, silver, real estate and commodities.

Ironically, cryptocurrencies, and in particular Bitcoin, may enjoy a reprieve from the recent bearishness, provided that investors come to some sort of agreement on the narrative behind the digital asset class – whether as an inflation hedge or a full-on risk asset.

Some suggest that as long as a recession is not imminent, markets are likely to be able to handle slightly higher rates without breaking down because ultimately, where else will investors put their money?

And so investors who are really looking for an inflation hedge can still rely on equities, provided that they pick them up regularly on pullbacks.

While assets such as gold have at best a tenuous claim to protecting against inflation (there is ample data that suggests it only works over extended periods of time), stocks have performed reliably and outperformed inflation.

3. U.S. Cryptocurrency Miners Cheer Reporting Rule Clarity

  • U.S. Treasury Department clarifies that certain cryptocurrency industry participants would not be expected to report user data, including miners and stakers

  • Move by U.S. Treasury Department to clarify reporting requirements should be seen as a victory for cryptocurrency industry participants who had long lobbied against the onerous disclosure burdens

While many adjectives can be used to describe cryptocurrency miners, being a “broker” is probably not one of them.

Cryptocurrency miners using specialized computer processing equipment on an industrial scale to secure blockchains for everything from Bitcoin to Ethereum, have long gained a bad rep for consuming copious amounts of electricity.

But whatever one’s view on cryptocurrency miners is, they are rarely viewed by anyone inside and outside of the industry as “brokers.”

However, tucked into the language of a U.S. bipartisan infrastructure bill were reporting requirements that would have made it mandatory for cryptocurrency miners to turn over information on their users’ transactions to the tax authorities.

Fortunately for U.S.-based cryptocurrency miners, the U.S. Treasury Department has indicated that miners or stakers (in proof-of-stake protocols) who validate cryptocurrency transactions, as well as hardware and software providers, would be spared the reporting requirements.

Tagging cryptocurrency industry participants as “brokers” forces them to collect and disclose detailed information on their users, including names and addresses, gross proceeds from sales and any capital gains or losses.

But the burden if foisted upon miners or stakers who secure a cryptocurrency blockchain would not only be impractical, but financially burdensome.

While there are plenty of blockchain analytics companies who could potentially facilitate obtaining such information, it would be difficult, if not impossible for cryptocurrency miners or stakers.

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